Access to International Capital
Do the Credit Ratings Agencies Help or Hurt?
Asymmetric Bias and Self-fulfilling Sovereign Defaults
David Tennant, Damien King, & Marlon Tracey
Paper
argues
that…
• CRAs have reason to be
biased against poor
countries
• Evidence suggests the
bias is statistically
significant
• The bias can be sufficient
to trigger
default/restructuring
Credit
Rating
Agency’s
Objective
CRAs wish to minimize both
cost (of acquiring
information) and inaccuracy
(of their ratings).
But there is a trade-off
between the two, since
accuracy is costly.
Characteristic
s of the
Ratings
Business
• It is costly to acquire
information on the
ability/willingness of a
sovereign to service debt
• The weaker a country’s
institutions, the poorer it is
and also the worse is the
quality of readily available
information
• Default by a highly rated
sovereign is worse
(reputationally) than failure to
default by a poorly rated one
4
Accuracy
costs
3
 COST
2
1
 UNDER-ESTIMATE
OVER-ESTIMATE 
0
-3
-2.5
-2
-1.5
-1
-0.5
0
0.5
1
1.5
2
2.5
3
 COST
Underestimating
default
likelihood
worse than
overestimating
 UNDER-ESTIMATE
OVER-ESTIMATE 
Striking a
balance =
overestimating
 COST
 UNDER-ESTIMATE
OVER-ESTIMATE 
 COST
Optimal
overestimation
worse the
more costly
it is to get
information
 UNDER-ESTIMATE
OVER-ESTIMATE 
Therefore
…
• CRA’s estimated
probability of default has a
bias, the strength of which
is inversely related to a
country’s level of
development.
• “Bias” because it is
independent of the
fundamentals that
determine a country’s
ability and willingness to
Paper
argues
that…
• CRAs have reason to be
biased against poor
countries
• Evidence suggests the
bias is statistically
significant
• The bias can be sufficient
to trigger
default/restructuring
Objective
of
Statistical
Estimation
Test CRAs decision to
downgrade, upgrade or
leave unchanged the
rating of a country’s
foreign currency
sovereign debt.
Statistical
testing
takes
account
of…
• Economic and institutional
fundamentals
• Debt, debt service, fiscal balance, GDP,
investment, reserves, inflation, CA balance,
Institutional quality
• Country specific fixed effects
• Some element of a country’s risk may be
particular to that country, e.g., social capital
• Heterogeneous thresholds
• Threshold for re-grade not same for all
countries
• Time-period dummies
• Willingness to re-grade changes over time
• Tempering
• General reluctance to change a rating due to
desire for stability and upper/lower limits
Data
• Countries: 142
• Years: 1997 to 2011
• CRAs: S&P, Moody’s, Fitch
Mean
Ratings
S&P
Low
Middle Upper
8.3
10.2 17.7
1.89
Moody’s
8.4
2.21
Fitch
8.3
2.26
3.26
3.14
10.3 17.8
3.25
3.22
10.4 18.0
3.37
3.10
Factors
Influencing
Ratings
Changes
S&P
∇ Debt
∇ Debt Service
∇ Real GDP per cap
∇ Investment
∇ ln Export
∇ Reserve/Import
∇ Current Account Bal.
∇ Inflation
∇ Institutional Quality
-5.89
1.98
0.09
3.65
2.67
0.11
-6.84
-3.99
1.11
Moody’s Fitch
-2.47
-5.76
0.83
-3.43
0.07
5.11
1.52
0.09
0.08
-2.67
-4.41
-0.45
-2.51
1.07
2.14
5.71
0.34
0.02
Factors
Influencing
Upgrade
Thresholds
S&P
Low Income
Middle Income
Moody’s Fitch
0.62
0.73
1.14
0.08
0.22
0.32
Paper
argues
that…
• CRAs have reason to be
biased against poor
countries
• Evidence suggests the
bias is statistically
significant
• The bias can be sufficient
to trigger
default/restructuring
Government’
s Objective
Governments wish to
minimize both taxes and
defaults.
But there is a trade-off
between the two since they
are alternative means of
financing.
Characteristic
s of Fiscal
Choices
• Defaulting is policy choice
• There is a fixed cost to
defaulting
• CRAs can see when a
government would be
better off by defaulting
To be
or not to be
(a
defaulter)
no default,
then govt
should…
If CRAs
expect
default,
then
govt
should…
y
default
default
not default
x
not
default
Conclusion
s
• Optimal for CRAs to overestimate the
probability of default
• Information acquisition costlier with poorer
countries
• Highly rated default is reputationally worse than a
poorly rated survivor
• Constitutes a bias
• Unrelated to ability and willingness to pay.
• Evidence that S&P, Moody’s, and Fitch are
reluctant to upgrade poorer countries
• There is a range of debt where a CRA
could rationally predict either default or no
default
• Within that range, poor countries are more
likely to get an unwarranted lower rating,
which can trigger a decision to default